Housing's Pillars Hold Firm

January 23, 2005

By Christopher Farrell Throughout 2004, most economists and Wall Street seers expected mortgage rates to rise above the 5% range, to 6%-plus or even breach the 7% level, saying they were unsustainably low and helping to contribute to a housing bubble. This was a concern because higher interest rates -- and consequently, higher mortgage rates -- would drag down the housing market, the best performing sector of the economy in recent years. Even more worrisome, economic research reports were full of woeful warnings over how the rate rises would push many overstretched homeowners into deep financial trouble.

As the Federal Reserve Board steadily hiked its benchmark interest rate from 1% to 2.5%, the rate on adjustable-rate mortgages correspondingly rose. But the long end of the market didn't behave as widely anticipated. Instead of rising -- the typical reaction whenever the Fed initiates a tighter money policy -- the yield on the traditional 30-year fixed-rate mortgage fell last year (see BW, 1/31/05, "The Mystery of the Sleeping Long Bonds").

DORMANT INFLATION. In the new year, Wall Street commentary is once again singing the same tune: Long-term interest rates are heading higher. Yet the decline in fixed-rate mortgages has continued in 2005, with the rate currently hovering around 5.25%. The odds are that mortgage rates will stay where they are or even trend irregularly lower this year. And this continued low level suggests the housing market's coming slowdown will be modest rather than cataclysmic in 2005.

Why should long-term mortgage rates come down? The expected rate of inflation plays a large role in setting long-term market rates. The more investors anticipate inflation, the higher the interest rate they demand to compensate them for the risk that a debauched currency will ravage the value of their fixed-income investment -- and vice versa.

But inflation isn't about to stir. The Federal Reserve Board is waging an open campaign to stem any resurgence in inflation by raising its benchmark interest rate. And consumers rebel whenever retailers try to raise prices.

BUBBLE DEBATE. Take the recent holiday season. Wal-Mart (which accounts for about 10% of the nation's retail sales) tried to avoid offering shoppers special promotions. And what did buyers do? They went elsewhere to find deals. Wal-Mart (WMT) got the message and quickly reversed course, whipping out the markdown pen. Delta Airlines' new low-fare strategy is wreaking havoc on its competitors. The Japanese auto makers are taking market share from the Big Three with generous incentives

With so little evidence of inflation, investors have reduced the yield on the benchmark 10-year Treasury bond from around 4.6% in June to about 4.2%. With inflation heading lower this year -- and the Fed continuing to raise its benchmark interest rate -- there's additional room for further decline in bond yields and mortgage rates. "When the Fed says it wants low inflation and that it's willing to further tighten monetary conditions, the record suggests it should be taken at its word," bond mavens Van R. Hoisington and Lacy H. Hunt of Hoisington Investment Management Company wrote in their fourth-quarter 2004 outlook.

What impact will continued low rates have on the housing market? The residential market has been on a tear, and home prices adjusted for inflation are up about 36% since 1995. That's roughly double the increase of previous home-price booms in the 1970s and 1980s.

Many analysts believe the housing market is developing a massive bubble that will soon burst, erasing much of the gain of recent years. Still, after a careful review of the residential real estate market and the bubble literature, economists Jonathan McCarthy and Richard W. Peach of the Federal Reserve Bank of New York conclude that the "most widely cited evidence of a bubble is not persuasive."

RISKS OF OPTIMISM. Indeed, homes remain affordable on average (assuming you don't live in New York, Los Angeles, or a few other high-cost cities) -- largely because of low rates. For instance, McCarthy and Peach compute a simple home-price-to-income ratio. The figure is between annual interest and principal payments at prevailing 30-year mortgage rates on a new single-family home (assuming a 20% down payment), and median family income. By this definition, 15% of family income is going toward housing costs on average. The number has been stable for the past several years and is as low as it has been in 25 years -- in sharp contrast to the conditions of the 1970s and 1980s when high home prices and high interest rates combined to erode cash-flow affordability.

True, there's anecdotal evidence that the housing market is losing steam in many areas of the country, especially in tony neighborhoods. But stagnation is a far cry from a catastrophic plunge reminiscent of the dot-com bust of 2000.

Still, these optimistic calculations could be upended by any number of economic crises in 2005. Foreign investors could go on strike, refusing to buy any more U.S. government debt, scared away by the twin federal budget and current account deficits. If the Administration succeeds in creating private accounts for Social Security, the transition cost will likely require $1 trillion to $2 trillion in additional government debt. The risk exists that the U.S. dollar's slide on foreign exchange markets turns into a stomach-churning rout.

BONDS GET NO RESPECT. These financial dangers are well known. Yet, some bearish money mangers and high-profile observers, frustrated that long-term interest rates have come down over the past year, argue that investors are willfully overlooking these potential pitfalls. Still, that's a tough argument to buy. Almost no Wall Street commentator and public policy maven likes bonds these days because the rates are too low. Like Rodney Dangerfield, bonds get no respect.

Big mistake. If the Fed succeeds in its stated mission and brings the inflation rate down, long-term interest rates aren't about to go up -- and that includes mortgage rates. Farrell is contributing economics editor for BusinessWeek. You can also hear him on Minnesota Public Radio's nationally syndicated finance program, Sound Money, as well as on public radio's business program Marketplace. Follow his Sound Money column, only on BusinessWeek Online